Wednesday, August 22, 2012

The Live off Dividends Retirement Plan

I often speak with investors who want to retire at some point in their lives. Unfortunately, we live in a world, where companies offering traditional pensions are shrinking in number. In addition, there is little assurance about the ability of the Social Security Fund to fund the same level of benefits for Gen X and Gen Y participants as it will for Baby Boomers. Add in uncertainties about potential for hyperinflation due to FED's printing presses, low interest rates on fixed income and a decade of zero stock market returns, and it is no wonder many people are afraid about their retirement prospects.

These investors are looking for a vehicle, that would give them the chance to overcome several risks they are facing. The risks include:

1) Inflation

2) Volatility

3) Taxes

4) Outliving one's money

5) Costs

In other words, investors are typically looking for an asset class, that would provide them with enough income to support them for the rest of their lives. This stream of income should be able to maintain its purchasing power, and should not be volatile. In addition, this income source should lead to as little in taxes as possible. Furthermore, this income stream should last for life and even be available to pass on to future generations. This income stream should also be relatively cheap to maintain and easy to convert into cash.

Dividend growth stocks represent share ownership in companies which can afford to regularly raise distributions. This is due to the fact that they are typically characterized by having wide-moat businesses, strong competitive advantages and strong brand names. This allows these companies to maintain pricing power, that allows them to pass on cost increases to consumers who are willing to pay a premium price for these products or services. As a result, this pricing power converts in companies' abilities to generate high earnings over time, which increases the odds of maintaining purchasing power of the dividend income stream.

The fact is that most prominent dividend growth stocks sell goods or services that are used by consumers on an everyday basis. Since most of these goods and services are essentials, the demand for them does not fall off during an economic downturn. They might postpone purchasing a new car or a new computer by a few years. Even during a recession, people still eat, shower, drive and buy groceries. This ability helps dividend growth companies in earning a sufficient amount even during the most tumultuous times in order to pay a consistent and rising dividend to shareholders. The predictability of the amount and timing of dividend payments, makes these income stocks ideal for retired investors. The fact that dividend investors use distributions from their portfolios to fund their expenses, makes it real easy to live off their nest eggs. Dividend investors do not need to worry about bear markets and selling off shares at depressed prices, because they simply live off the dividends that their income portfolios generate. In addition, these investors know exactly how much income they can expect to receive from their portfolio for the week, month or year. As long as these dividends are at least maintained, investors should be able to fairly easily estimate their dividend incomes for any given timeframe.

In addition to that, dividend income is one of the most efficient taxable form of income available to investors. Currently, the top tax rate on dividends is 15%. The top tax rate on dividends is equal to the highest tax rate on capital gains. The main difference is that dividend income is fairly predictable and less volatile than capital gains. The interest on Corporate and Federal Bonds is taxed as ordinary income. Even if the tax on dividends is increased, it is unlikely that investors who make less than $100,000 in annual dividend incomes will be affected by too much.

The types of core dividend stocks for any income portfolios include companies such as:

Philip Morris International Inc.(PM), through its subsidiaries, manufactures and sells cigarettes and other tobacco products. This Consumer Goods company has managed to boost distributions every year since the spin-off from Altria in 2008. Emerging Markets growth, acquisitions and strong pricing power will be some of the key factors driving future profitability and dividend growth. The stock trades at a P/E of 18.60 and yields 3.40%. (analysis)

PepsiCo, Inc. (PEP) engages in the manufacture and sale of snacks, carbonated and non-carbonated beverages, dairy products, and other foods worldwide. I find Consumer Goods company to be a better value than arch rival Coca-Cola at the moment, while I find both to have similar growth characteristics going forward. Coca-Cola (KO) is trading at 20.90 times earnings and yields 2.60%, while PepsiCo yields 3% and trades at 19.30 times earnings. PepsiCo has managed to boost distributions for 40 years in a row, and has a ten year dividend growth of 13.30%/year. (analysis)

Abbott Laboratories (ABT) engages in the discovery, development, manufacture, and sale of health care products worldwide. This Healthcare company is cheaper than what popular sites like Yahoo! show right now, since the earnings figures are including one-time items. I find it attractively valued at 16.50 times earnings and yielding 3.10%. Abbott has raised dividends for 40 years in a row,and has a ten year dividend growth rate of 8.70%/year. Abbott announced its intent to split in two companies in October 2011. (analysis)

Chevron Corporation (CVX), through its subsidiaries, engages in petroleum, chemicals, mining, power generation, and energy operations worldwide. This integrated energy company has one of the best reserve replacement ratios in the industry. It is also attractively valued at 8.40 times earnings and yields 3.20%. It has raised dividends at 8.80%/year over the past decade. The company plans to spend $37 billion/year in capital spending over the next five years. The company is targeting over 22 projects, that will deliver 1 million BOE/day by 2016. The major projects that are expected to be brought online include Kashagan Phase 1 project in Kazakhstan, Kearl Oil Sands Project in Canada as well as a few in Africa. Its recent deal with Rosneft to explore in the Arctic and Black seas could generate long-term dividends for the corporation, which has tried to do business in Russia for years. (analysis)

Automatic Data Processing, Inc. (ADP) provides business outsourcing solutions. The company operates in three segments: Employer Services, Professional Employer Organization (PEO) Services, and Dealer Services. This technology company is expecting higher revenues as a result of acquisitions, improving client retention rates, and increased North American auto sales, which would boost its Dealer Services segment. The hidden growth kick behind ADP is the relatively untapped market for payroll outsourcing services for small and medium sized businesses. The company has boosted dividends for 37 years in a row and has a ten year dividend growth rate of 13.40%/year. It is attractively valued at 20 times earnings and yields 3.20%. (analysis)

Kinder Morgan Energy Partners, L.P. (KMP) operates as a pipeline transportation and energy storage company in North America. The partnership expects its acquisition of El Paso to generate significant synergies and cost savings starting from year one. It also plans on increasing distributions in 2012 to $4.98/unit. Kinder Morgan expects future distribution growth to average 5%-6% over the next several years, as it expands its network of fee generating assets. This dividend achiever has boosted distributions for 16 years in a row and has a ten year distribution growth rate of %/year. Yield: 6.10% (analysis)

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